Position management or exit strategies for covered call writing and selling puts is the third required skill to achieve the highest possible return levels (stock and option selection are the first two). First, we must determine if an exit strategy opportunity actually exists and then, if so, which one to execute. On May 3rd 2019, Rob N wrote to me regarding a successful trade he was involved with and was considering a rolling strategy in the same contract month. This article will dissect the pros and cons of rolling up in the same contract month and evaluate if this is the best course to take.
Rob’s trade with CarMax, Inc. (NYSE: KMX)
- 4/25/2019: Buy 100 x KMX at $75.89
- 4/25/2019: Sell 1 x $78.00 call (May 17 expiration) at $1.42
- 5/3/2019: KMX trading at $78.50
- 5/3/2019: Cost-to-close the $78.00 call is $1.15
Initial structuring of the trade using The Ellman Calculator
KMX: Initial Calculations with the Multiple Tab of The Ellman Calculator
Rob received an initial 23-day return of the option (ROO) of 1.9% with an additional upside potential share growth of 2.8% resulting in a 23-day potential return of 4.7%. This is where the trade is positioned as of Rob’s email on 5/3/2019. For a free version of The Basic Ellman Calculator click here.
Evaluating rolling up in the same contract month
Rob was considering 3 paths to take:
- Rolling up to the $79.00 strike for an option net debit of $0.55 ($1.70 – $1.15)
- Rolling up to the $80.00 strike for an option net debit of $0.95 ($1.70 – $0.75)
- Taking no action and possibly getting assigned after expiration
Now, why would we roll up to then lose money on the options? Frequently, moving the strike up will create an unrealized stock gain to the strike or current market value of the stock, whichever is lower. In this case, share value would move up $0.50 from the original $78.00 strike to current market value of $78.50. In both cases, we would be rolling up to a losing scenario. Should share price move up to the new strikes, we would now have net credits in both rolling scenarios:
- $79.00 strike: (-$0.55 + $0.50 + $0.50) = +$0.45 = 0.6%
- $80.00 strike: (-$0.95 +$0.50 + $1.50) = +$1.05 = 1.3%
To achieve these relatively small additional credits and avoid losses on the option side, we would be dependent on continued share appreciation of a stock that has recently enjoyed significant price acceleration. In a way, we are taking a (currently) very successful trade and putting the results at risk.
Best strategy when share value increases significantly mid-contract
The mid-contract unwind exit strategy can be employed when the time value component of the premium approaches zero or such that closing the entire position and using the now available cash will allow us to generate at least 1% more than the time-value cost-to-close. For this calculation, we use the “Unwind Now” tab of the Elite version of the Ellman Calculator:
Time-Value Cost-To-Close Using the Elite Version of The Ellman Calculator
The calculator shows a cost-to-close of $120.00 per contract or 1.54% of current market value. The original return was 1.9% so closing the entire position is way too expensive and not appropriate at this. It may become viable should share price continue to accelerate in the next few days.
Discussion
There are many times when the best action is no action at all. In this case, Rob has maximized his initial trade as long as share value remains at or above $78.00. We must remain focused and prepared to act should a viable exit strategy opportunity arise. If the strike remains in-the-money as expiration approaches, there is also the opportunity to roll the option out or roll-out-and-up to the next contract month.
***For more information on position management for covered call writing, see the exit strategy chapters and sections in these educational products:
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https://www.moneyshow.com/video/11655/selecting-the-right-strike-price/
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Hi Alan,
I’m having trouble understanding the breakeven concept.
For ITM covered calls, is it strike price minus the time value or is it the original share purchase price minus the original contract premium?
Both calculations yielded the same number in your example.
– Ted
Ted,
The formula for breakeven for all strikes is:
BE = Share price – entire option premium
If a stock is trading at $48.00 when we enter a covered call trade and we generate $1.50 in premium for the $50 out-of-the-money strike, our BE = $46.50 ($48.00 – $1.50).
Now let’s say, we sell an in-the-money $45.00 call for $4.00, our BE = $44.00 ($48.00 – $4.00).
Deducting time-value from the strike for in-the-money strikes is accomplishing the same thing but in 2 steps. To get from the stock price to the strike, we are deducting the intrinsic-value of the premium ($48.00 – 3.00) = $45.00. Now, we deduct the time-value component ($1.00) to get to our $44.00 BE. Both formulas end up in the same place. Use this formula for BE for all strikes:
BE = Share price when trade is entered – entire option premium
Good question.
Alan
Premium Members,
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 10/11/19.
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Best,
Barry and The Blue Collar Investor Team
barry@thebluecollarinvestor.com
NEW BLUE CHIP REPORT:
Premium members,
The Blue Chip Report of eligible Dow 30 stocks for the November contracts has been uploaded to the member site in the “resources/downloads” section (right side).
One stock was deleted and 3 were added from last month’s report
Alan
Hi Alan,
I sold an ITM covered call for GDXJ on 10/9/19.
I bought the shares at 38.07
Strike price is 37.50 with an expiration date of 10/25/19.
ETF is currently trading at 37.04.
I’m trying to figure out what to do next. I realize you can’t give investment advice, but I’m thinking of just unwinding everything.
Since it’s a weekly option, should I be using the weekly chart information or stick with a monthly? I should have asked this before.
Any thoughts on the matter would be appreciated.
– Ted
Ted,
When share price moves down, we use our 20%/10% guidelines to determine when to close the short call. If a stock is significantly under-performing the market, we may decide to close the entire trade. When none of the scenarios are evident, there may be no reason to execute an exit strategy.
I’ve attached a screenshot of the technical parameters we use in the BCI methodology
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
What was your initial goal? When looking at the chart, GDXJ had just made a 7.3% move up on the close 10/8/19. And you picked a Wednesday to enter on a weekly option…..not sure why you choose that day. The overall trend looks down. Recent lower high. MACD has been under the zero line for a month…..your impression should have been stock is going down. The price action seems to like the 20 EMA and the 100 SMA. The most recent low was right at the 100 SMA for 2 bars…..really this is where the trade should have been placed. You have a down bar showing support and the next day confirming that support. The ATR for a week on GDXJ is $2.49. You sold an ITM call just $0.50 from your cost basis on a down trending chart with a recent 7% move up…….. This was a bad setup. You must look at the candles…..there are huge wicks the prior week….this is opportunity to get burned. And you did. This chart was screaming I am moving down. And you gave yourself no downside protection. I hope you are keeping a journal….I traded for years without one….once I started one, I became significantly better. When you force yourself to explain why you should take a trade, the risks of this trade prior to taken the trade you will see the pitfalls.
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Alan and the BCI team
Hi Alan,
I don’t mean to be a pest, but I’m having trouble understanding the concept of “intrinsic value” as it relates to this video.
Original Covered Call “CC” was sold for $4.40. But if they have to pay $4.80 to close the contract, don’t they have a Total Loss of -.40?
I understand the placing of the BTC at 4.80 since the Bid was 4.50 and Ask was 5.00.
If the BTC is executed at 4.80, you state that the intrinsic value is 4.50 = money we don’t lose by closing the trade.
And of the 4.80, .30 is time value = cost to close the trade.
I’m having trouble following this.
I understand that they are out the difference between the original premium received (4.40) and what they need to pay to close the contract (4.80) = – .40
How is there still a return of 2.1% ?
I thought intrinsic value was: share price – strike price
– Ted
Ted,
This is an important concept we must master. Let’s say we sold a $50.00 strike and the stock is currently trading at $54.50. At this point in time our shares can be valued no higher than $50.00 due to our contract obligation.
Now, if the cost-to-close is $4.80, the breakdown is $4.50 intrinsic value + $0.30 time value. This means that once we close our original short call ($50.00 strike), our shares are now worth market value of $54.50, an increase of $4.50. This leaves the actual time-value cost-to-close at $0.30. Yes, we are spending $4.80 on the option side, but we are gaining $4.50 on the stock side.
Use the “Unwind Now” tab of the Elite version of the Ellman Calculator to run several of these trades if closing mid-contract or the “What Now” tab if rolling options.
Alan